The Beer Goggles Stock Market

If you’re ever headed down Topperwein Road in Live Oak, Texas with a need to unwind and bend an elbow, pull on in at the town’s local watering hole, the Beer Goggles Bar, and order up a cold one. The bartenders are reported to always be on their ‘A’ game and the music next to none.

CAPE

It is of course only fitting that a bar in Texas named for the propensity of alcohol to render members of the opposite sex more attractive not be given a soft flowery name. Can’t picture a parking lot full of mud-caked pickup trucks bellied-up to the Rose Colored Glasses Lounge.

Though the two idioms reference a similar phenomenon, it’s only the origin of rose-colored that’s a matter of dispute. Going back to the 17th century, it might have been the popularity of romantic imagery in art work which inspired viewers to associate optimism with the colors of painted rose gardens. Victorians also liked the idea of a “rosy glow” or painting a rosy picture by adding extraneous roses to liven up their art. A less romantic origin could have come from the use of rose petals by early map makers to clean the lenses of their eyeglasses to the extent that the oils left their spectacles literally rosy.

[drizzle]

Some say it was in merry old England that the phrase rose-tinted spectacles was first turned? Or, it might have been the romantic French who coined it? Literary history gave us this in 1841: “L’optimiste souriant qui regarde la vie a travers des lunettes roses.” In the event your language of love is a rusty, that translates to, “The smiling optimist who looks at life through rose-colored glasses.”

A Wall Street Journal story that ran last week categorically dispensed with the notion that investors were looking at stock market valuation too optimistically. The bears simply have a measurement issue. The road to happiness for these growling party poopers? A refresher in accounting. Many of us are familiar with Robert Shiller who among other economic feats made famous his cyclically-adjusted price-earnings ratio, or CAPE. The method is simple and elegant — smooth out the ups and downs that rattle earnings trends by valuing shares based not on one, but rather 10 years of earnings.

The CAPE’s efficacy gained in stature as the years passed for its ability to predict the future direction of the stock market. And what’s not to like about that? But then along came some accounting changes that effectively pressured earnings downwards, which in turn made the CAPE ratio flash overvaluation where it once would not have, as it is today at 27 suggesting stocks are more overvalued than at any time but the peak of the tech bubble and 1929.

The article goes on to highlight an alternative to the CAPE which gauges valuation based on those same 10 years, but uses Commerce Department quarterly data, which has the benefit of consistency over time. With that, the voila moment arrives: The scrubbed clean P/E ratio comes in at 19, a smidge over its 50-year average of 17, but nowhere near the 39 sported during the dotcom bubble or even the 24 level that marked stocks’ 2007 peak.

So come on in! The water’s just right! Suffice it to say, the neatness of the article’s conclusion did not sit right with yours truly.

In the giving credit where credit is due department, The Lindsey Group’s Peter Boockvar first coined “beer goggles” to describe investors’ forgiving attitude towards risky assets and stocks especially. The source of the insouciance, you ask? The soothing flows of quantitative easing that clouded investors’ collective judgement.

“From their trough in 2009, corporate earnings have been gussied up by extremely low interest expense, lower tax rates, a reduced share of profits going to labor (fell to the lowest in the post WWII period), reduced depreciation expense due to a slower rate of capital spending and massive stock buybacks,” explained Boockvar in a recent chat. “Thus, the earnings recovery should be considered low quality.”

On that last count, the math is lacking on the aggregate effect of share repurchases on stock valuations. But there are some data that shed light on the power of buybacks to bolster stock prices.

Goldman Sachs figures that companies in the Standard & Poor’s 500 (S&P 500) index directed nearly a third of their cash to buybacks last year. S&P looked instead through the prism of reported earnings and determined that dividends and buybacks have represented an average of 85 percent of earnings since 1998 with the two exceptions of recession years 2001 and 2008.

Reuters expanded the pool to peer into the behavior of the 3,297 publicly traded non-financials and found that almost 60 percent of the companies have bought back their shares since 2010. Until recently, the trend was in full blown acceleration mode. 2014 clocked in as the first in which spending on dividends and buybacks exceeded companies’ combined net income. Firms’ excessive enthusiasm carried well into 2015.

As for what we the people have to show for what’s been returned to shareholders, it can be best summed up as something south of a goose egg. Among the 1,900 companies giving it all back and then some, their largess tallied to 113 percent of capital spending, up from 60 percent in 2000 and 38 percent in 1990. And they say we have a productivity conundrum in this country? Do you see any gray area given companies aren’t even deploying capital to then return to shareholders?

As UBS’ legendary Arthur Cashin once quipped, “Such environments raise the not-so-fine art of financial engineering to a ‘botox state.’”

Yet another Wall Street legend, Warren Buffett, has been known to sound the warning of the perils of rich buybacks. In his 2012 letter to Berkshire Hathaway shareholders, Buffett reminded his readers that the most important factor that feeds a buyback decision should be price: “Value is destroyed when purchases are made above intrinsic value.” (Maybe IBM’s copy of the report got lost in the mail that year.)

So companies have thrown over $7 trillion into buybacks since 2004, aggressively reducing share count in the process, and we’re supposed to disregard the effect of this massive booster shot on reported earnings per share? Does that sit right with you?

In the event buybacks have yet to get under your skin, in August J.P. Morgan reported that 39 percent of buybacks thus far this year were funded by issuing new debt, nearly double the 22 percent in the same period in 2015. There’s no denying stocks are near record highs. The question then becomes one of the value shareholders think they’re getting vs. what is actually being “destroyed,” to borrow Buffett’s word.

With fresh corporate debt flooding at a record pace, you can bet your bottom dollar there’s more to come despite buybacks ebbing a bit. The question is, how distorted are earnings due to the unprecedented buyback binge, to say nothing of the other factors Boockvar mentioned? It should strike you as a bit presumptuous to debate which P/E ratio is best to use when it’s impossible to quantify the aggregate flatter factor care not only of buybacks, but also appreciably lower taxes and interest expenses that barely register in positive territory. The working assumption that rational interest rates are a myth is thus dangerous bordering on reckless.

Boockvar suggests that investors who prefer to sleep at night gauge valuation through a clearer prism: “Instead of pricing equities off this fragile state of earnings, look at valuations compared to revenue, which cannot be manipulated. This should give a better metric of how overvalued the equity market currently is.”

What’s not to like about dividing a company’s market capitalization by its sales over the last twelve months? Hard to manipulate that. Sequestering the stocks in the S&P 500 reveals that at a median of 2.3-times sales, companies are more overvalued than ever. In the event you’d like a bit of historic context, the two-level was never breached in 1999 or 2007.

With that, it would seem to be high time to don your rose-colored glasses. Reality, it would seem, is too expensive to see with naked eyes. If you prefer, you can Redneck the exercise and pop on a pair of beer goggles. You might even want to mosey on down to Live Oak for a frothy brew to celebrate how reasonably stocks are valued. If you do, be sure to ask for the bartender Danielle by name. The reviews say she’s the best of the best. But no, in case you’re curious, no relation at all.

Author: Danielle DiMartinoCalled "The Dallas Fed's Resident Soothsayer" by D Magazine, Danielle DiMartino Booth is sought after for her depth of knowledge on the economy and financial markets. She is a well-known speaker who can tailor her message to a myriad of audiences, once spending a week crossing the ocean to present to groups as diverse as the Portfolio Management Institute in Newport Beach, the Global Interdependence Center in London and the Four States Forestry Association in Texarkana.
Danielle spent nine years as a Senior Financial Analyst with the Federal Reserve of Dallas and served as an Advisor on monetary policy to Dallas Federal Reserve President Richard W. Fisher until his retirement in March 2015. She researches, writes and speaks on the financial markets, focusing recently on the ramifications of credit issuance and how it has driven equity and real estate market valuations.
Sounding an early warning about the housing bubble in the 2000s, Danielle makes bold predictions based on meticulous research and her unique perspective honed from years in central banking and on Wall Street.
Danielle began her career in New York at Credit Suisse and Donaldson, Lufkin & Jenrette where she worked in the fixed income, public equity and private equity markets. Danielle earned her BBA as a College of Business Scholar at the University of Texas at San Antonio. She holds an MBA in Finance and International Business from the University of Texas at Austin and an MS in Journalism from Columbia University.
Danielle resides in University Park, Texas, with her husband John and their four children. In addition to many volunteer hours spent at her children's schools, she serves on the Board of Management of the Park Cities YMCA.